Let domestic oil prices reflect global scarcity

NEW DELHI: The future, mused the mystic, is made of the same stuff as the present. A down-to-earth observation, that. Consider, for instance, the future price trend of key commodities like metals and petroleum crude.

In these times of buoyant growth and heightened resource usage, what is the outlook for commodity prices? The figures suggest that the prices, net of inflation, have actually declined over the long term.

A similar price behaviour in the years ahead would require clear-cut policy initiatives to get the relative prices right, so as to bring about optimal resource allocation and sustained improvements in efficiency levels. Commodity prices remain inherently volatile. Crude oil prices have, for example, slid considerably in recent weeks on the face of weaker demand and reduced geo-political risk perceptions.

The benchmark price of a barrel of West Texas Intermediate crude has dropped 18% in a month. As for metals, the Economist Commodity price index shows 6% fall since December, after as much as 35% hardening of prices year-on-year. Yet the fact is that real non-oil commodity prices have declined for more than a century, as revealed by a recent World Bank paper.

Over the years, technological developments and productivity gains have cut down on costs and revved up supply. Real oil prices have shot up relative to circa 1900, but have remained below 1980 highs notwithstanding the price flare-up in the last two years. The question is whether the future price trend would be quite different, what with strong demand emanating for high-growth economies like China and India. There are concerns over supply shortfalls, and disquiet about rising production costs.

In oil, cartelisation pressures could in fact keep prices well over production costs. Also, the growing attraction of commodities as an asset class could fuel speculation and prop up prices, with hedge funds building up excessive long positions. But over all, a studied reading of the economic tea leaves suggests that commodity prices are likely to remain cyclical and volatile, but not permanently elevated.

Generally speaking, there is no shortage of metal resources expected in the next two decades and beyond. What is expected though is that new projects would likely be in more difficult locations and so may raise development costs. There are also worries about declining ore grades.

The key to stem the secular rise in production costs in metals is to improve mining and smelting operations with technological change and better project management. Oil is expected to remain the largest fuel in the energy mix over the next two decades. But unlike metals, oil output is forecast to grow by no more than a third over the period.

During that time, the International Energy Agency sees oil output rising by 25 million barrels a day, or just about 1.5% per annum. The highest rate of increase, of up to 3% annually, is likely to be in China and India. The expert opinion is that there is no real resource constraint in oil well into the distant future. The prognosis is that high oil prices would impact both demand and supply, and that the pressure over the secular period would be to reduce prices though perhaps not to levels seen in the 1990s. New technologies, like hybrids, could reduce oil use in the transport sector.

In metals, prices would in the main depend on the ability of producers to hike capacity to meet demand. What���s billed is a moderate increase in the cost curve for most metals in real terms, due to rising energy, material and wage costs. Iron ore and nickel could see the largest increase in the cost curves, with large infrastructure costs on the cards in the case of iron ore and expensive new technology upping costs for nickel.

As for non-ferrous metals, the world-wide demand for both aluminium and copper is expected to double in the next two decades. In aluminium, China and India are expected to account for more than half the demand growth with transport expected to post the largest sectoral increase. For copper, construction is likely to remain the main industry of demand, with transport and electronics following at the heels. It remains to be seen whether long-term prices in metals would reflect the long-run marginal costs of production.

With rising oil prices, there have been claims now and again that ���the world is running out of oil.��� But the fact remains that projections of non-OPEC supply, which now account for the bulk of global oil output, have historically been pessimistic. Since non-OPEC supply estimates are almost certainly understated, a long-term easing of oil prices cannot really be ruled out.

Be that as it may, the way ahead to cope with price uncertainty in metals and oil is to have transparent policies in place so that domestic prices do reflect international scarcity value. For heavily traded commodities, global prices are the right benchmark to shore up domestic supply and efficiency.