Detoxify oil pricing

On October 15, 2018, interacting with global leaders from the energy sector in New Delhi, prime minister, Narendra Modi had expressed concern over the steep increase in the international price of crude oil [then the price had touched US$ 80 per barrel leading to corresponding increase in price of diesel and petrol; this even hurt BJP politically as the party lost three state assembly elections viz Madhya Pradesh, Rajasthan and Chattisgarh] and urged all leading producers/exporters to be more responsible in fixing the price to bring it down from current high to reasonable level.

Then, he might not have even contemplated of a scenario wherein the price of crude would plunge to a fraction of the October 2018 level; on April 22, 2020, Brent crude was ruling at just about US$ 15 per barrel. In fact, the WTI [West Texas Intermediate] crude price went into the negative territory at minus US$40 per barrel. A negative price connotes that the seller is willing to pay the buyer for lifting the product as the former has no place to store and it is not possible to abruptly stop production due to technical reasons. What has led to a complete turnaround ?

Already, during 2019 particularly in the second half, global surplus was building up which led to decline in price to US$ 60 per barrel; the trend continued till early 2020. By March, 2020, the surplus intensified due the failure of OPEC [Organization of Petroleum Exporting Countries] + to agree to production cut. Meanwhile, there was exponential growth in Corona cases forcing global lock-down which led to destruction of oil demand on a scale never seen before. According to Research firm Rystad Energy, during April, there is excess supply of about 27.4 million barrels per day [mbpd].

Despite a historic agreement by OPEC + countries on April 10, 2020 to cut supplies by 10 mbpd [this cut will continue to remain in force until July, 2020], a huge demand-supply mismatch remains. This is what has caused precipitous decline in price. Even after the crisis is over [when, this is a million dollar question which only time will answer] the supply-demand imbalance will remain with price expected to be stay well below US$ 30 per barrel for a fairly long period.

These developments hold important lessons for stakeholders on both  sides of the fence viz. sellers and buyers of both crude oil and gas in the international market.

From the sellers perspective, events have convincingly demonstrated that their actions to manipulate the price by orchestrating well coordinated production cut don’t always succeed. If, they could manage to extract a price as high as close to US$ 150 per barrel [as in 2008] or US$ 117 per barrel [as in 2014], it can also decline steeply to a low of US$ 10 per barrel [as in 1997] or US$ 26 per barrel in early 2016 and now to US$ 15 per barrel currently.

The short point is in a market where price determination is entirely dependent on the supply and demand factors – irrespective of the cost of production – the demand is as much crucial as supply. Thus, in 2008 when global demand was increasing exponentially [courtesy, pump-priming by developed countries in the wake of Lehman financial crisis     besides major boosters from China and India], the price skyrocketed. Now, when Covid – 19 has annihilated demand from all over the globe, it has plunged to a low of US$ 15 per barrel.

This [Covid – 19] being once in a life time exogenous event, oil exporters may be tempted to think that after this, it will be business as usual; hence their ability to extract higher price from importing countries. This is flawed thinking. The OPEC should realize that their attempt to extract a pound of flesh in the past [that manifest in the oil crisis of 1973 and 1979] prompted USA – then a net importer – to develop its own resources. As a consequence, the latter catapulted itself to one of net oil exporter.

With a share of about 60% in total oil exports, the hold of OPEC bloc on the market has substantially diminished. Now, it needs the support of other non-OPEC exporters led by Russia to prop up the price. Even if both OPEC and non-OPEC act together [as they have been doing since January 2017], they will have to introspect whether or not by crippling the resource position of importing countries [inevitable, if the price is high], they will end up harming their own interest.

This is where the clarion call given by Indian Prime Minister in October 2018 and thereafter reiterated by oil minister, Dharmendra Pradhan on umpteen occasions to exporters for exercising restraint in pricing assumes significance. While, deciding their pricing policies, the latter need to strike a judicious balance between maximizing their revenue on the one hand and ensuring that the demand does not collapse. That the price had plummeted by 50% [even before Corona monster came in its deadly form] should serve as a warning signal.

For decades, oil exporters have got attuned to spending extravaganza purely on the strength of high revenue from export of oil based on exorbitant price charged from importers. For Saudi Arabia – the lead exporter from OPEC group – nearly 87% of its budget is supported from oil revenue. This is a dangerous situation; even if the low price scenario continues for a couple of years [a distinct possibility in the current context when restoration of growth to normal level world-wide is bound to be a long-drawn process], this could increase fiscal stress to unsustainable level. For smaller countries like Mexico or Venezuela which are totally dependent on revenue from oil export for their economic survival, this could lead to a catastrophic.

Saudi Arabia has sensed it; accordingly, it is looking for opportunities to diversify its sources of income to reduce its over-dependence on crude. In pursuit of this strategy, last year, it unleashed plans to invest US$100 billion in India’s downstream sector including refining, petrochemicals, retailing etc. This includes Aramco’s – the state controlled energy giant – proposal to acquire 25% equity in the US$ 60 billion West Coast refinery and petrochemical project in Maharashtra in which 50% will be owned by Indian Oil Corporation Limited [IOCL], Bharat Petroleum Corporation Limited [BPCL] and Hindustan Petroleum Corporation Limited [HPCL] and remaining 25% by Abu Dhabi National Oil Company [ADNOC]. Aramco is also picking up 20% equity in oil and gas assets of Reliance Industries Ltd [RIL].

Saudi Arabia and other oil exporters from the middle-east should pursue this strategy aggressively. While, reducing their vulnerability to fluctuation in the price of crude and resulting revenue loss, this will also drive them towards more ‘reasonable’ and ‘responsible’ in dealing with importing countries like India.

There are lessons for India as well. First, even if it pursues indigenization at an accelerated pace [unlikely, as during the last 5 years or so, despite loud talk of increasing domestic production, our dependence on import has only increased from a little less than 80% to 85% currently], we will continue to import an overwhelming share of our requirements.
Hence, there is dire need to improve our import management strategy aimed at maximizing gain when the price falls and minimizing loss when it increases. The present arrangement has too many gaping holes or else, how does one explain an ‘inventory loss’ of about Rs 25,000 crore by our oil PSUs viz. IOCL/BPCL/HPCL due to recent plunge in price [this represents the difference between the price at which the product in storage was imported and the current price].

Second, when the government expects oil exporters to charge less from India, the same logic should apply when the product is sold to Indian consumers. That does not happen. When, the price increases the same is passed on to the consumer. Even when the price goes down, the consumer does not get the benefit as then the union increases central excise duty [CED]. In case of gas, even as CED is ‘nil’ the price to users increases on account of high VAT [value added tax] levied by state governments.

There is also the fortuitous benefit [it often goes unnoticed] that accrues to upstream crude producing PSUs viz. Oil and Natural Gas Corporation [ONGC], Oil India Limited [OIL] [they produce nearly 15% of India’s requirements] due to high international oil prices – albeit at the expense of consumers. Be it a desire to collect more tax revenue or enable PSUs to garner higher profit, any attempt to increase price to consumers should be avoided on the same logic as India uses while advocating ‘responsible’ pricing by oil exporters.

Whether, it is oil supplies from OPEC/non-OPEC or domestic supplies, the overarching consideration in pricing should be to ensure that the product is ‘affordable’ to the end consumers [majority of them being poor]. Without ensuring this, there will be large-scale demand destruction which is bad omen even for suppliers.