Oil slump: No room for complacency

With its predominant hold over transportation which has pervaded most economic activities in human life in one form or another, the bull run of crude oil during early 2008 affected all the importing nations. Some of the nations passed the burden of rising crude oil prices onto the stakeholders and most others passed it partially, bearing the brunt of it in their budgets with the hope that the situation would reverse soon. Market analysts too were divided on their take on the direction of crude prices, and those who were of the belief that it would reverse, feared the domino effects it could create given the extensive participation of the economic stakeholders from developing nations in crude markets.

Looking at the pace of bull-run, analysts predicting the reversal even feared that it could cause a major damage to institutions in developed economies with its ripple effects seemingly passed on through the globally integrated network of commerce and trade to other nations. Thanks to the initial spark to the current financial crisis in the form of the subprime crisis which started earlier to the crude market reversal, the crude effect had become a subset of the whole crisis that the global financial institutions are currently facing.

Interestingly, as the crude prices came down and in economies where the effects were immediately passed on, much of the purchasing power had already been washed off due to the credit crisis that had already crippled them and hence could not help build up demand sentiments. This resulted in building up of bearish sentiments in both the physical and derivative markets leading to the reversal of the increasing trend in crude prices with a fall that is steeper than its earlier rise. As the credit and other related bubbles bust, it took the other asset classes on a downward path due to weakening demand sentiments. Crude being one among the commodity asset class, its fall would have definitely provided relief to the policy makers of the largely import dependent emerging economies such as that of China and India. Though the effect of it, particularly in India had not been passed on fully for it to get reflected in other sectors, the prices of other commodities have fallen either due to increased supplies or the weak demand affected by the current financial crisis. Besides, after the elections were over, the government had announced a cautious cut on crude derivative prices by 5%-10%.

Since the issue of cross-border terrorism has hogged all attention, the price cut did not attract much comment. However, there have been public remarks as to the quantum of cut in the media. Setting aside the refining economics that many would feign ignorance about, one should appreciate the recent quantum of reduction if one were to agree with the below analysis. The moot point is that oil prices at the current level can harm the overall oil economy more than it could benefit the importing countries.

As everyone would know, the increase in crude oil production to a large extent is dependent on increased investments in exploration incentivised by higher oil prices. Contrarily, the current low prices had already taken a toll on the Federal Government of Nigeria, the world's seventh largest exporter of crude oil which had presented a deficit budget of Nigerian Niara 800 billion for its 2009 budget with a benchmark of $45 per barrel.

A country that had already been riddled with high incidence of socioeconomic problems, lower government spending would further worsen the socio-economic situation in Nigeria. Even if exploration were to be made with external funding, with worsening socio-economic situation it would not incentivise any interest abroad to bid for new fields that may be thrown open. Another nation that is increasingly trying to reduce the dependence of its budget on oil revenues is Iran, with the current fall in oil prices, as part of its good governance. According to President Ahmadinejad, his government has cut dependence of the budget plan on oil revenues by 10%, i.e., from about 62% of the previous budget plan, the current budget plan has only envisaged 52% of the total revenues attributed to oil-related income. While it is good that a nation is reducing its dependence on a single source of revenue, it would be interesting to watch its implications on government spending and efforts to develop other sources of revenue without pumping more oil from the existing reservoir at current prices. Obviously, for a not so open economy in terms of foreign investments such as Iran, it would only mean that there will not be supply augmentation beyond a point.

Amongst the top producers, Russia too is facing the perils of its gloomy oil and gas industry. To sustain production, Russia needs to overcome the 'Greenfield challenge', i.e., the need to develop remote and capital-intensive new oil and gas fields in an environment where newly created "national oil and gas champions" are too heavily leveraged with debts. According to estimates (2008-10), Gazprom, the Russian oil and gas major, faces a high probability of its cash flow moving in loss territory by 2009. As a result, now when many of Russia's brownfield oil and gas potential are on the verge of expiring, the development of the greenfield potential to compensate their losses is proving to be difficult as it requires increased capital investment.

Having been convinced of the implications of current low oil prices to the entire oil economy and taking into account the opposition that the Indian government faces while revising petroleum product prices upward, despite the huge fiscal burden to the exchequer and accumulated losses to the oil companies, it would be unwise to call for further reduction in the administered prices unless the economic situation and the oil prices warrant the same. However, it would be wise if the government strategically tackles the effects of oil price movements through increased participation in overseas exploration, participation in derivative markets, augmentation of domestic production and last but not the least focus on research in alternative energy sources keeping in mind its long payback period.

(The author is chief economist, MCX)