Detoxify oil pricing

by May 5, 2020 0 comments

The COVID-19 outbreak is a rare event and oil exporters may think that after this ends they can continue to extract a higher price from importing countries. This is flawed thinking

On October 15, 2018, while 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 prices of crude oil (at $80 per barrel leading to corresponding increase in price of diesel and petrol) and had urged all leading producers/exporters to be more responsible in fixing the price, to bring it down  to a reasonable level.

At that time, no one had even contemplated a scenario wherein the price of crude would plunge to a fraction of the October 2018 level. On April 22, Brent crude was ruling at just about $15 per barrel. In fact, the WTI (West Texas Intermediate) crude price went into the negative territory at minus $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, a global surplus was building up which led to a decline in price to $60 per barrel and the trend continued till the beginning of this year. By March the surplus intensified due to the failure of the Organisation of Petroleum Exporting Countries (OPEC) to agree to a production cut.

Meanwhile, there was an exponential growth in Coronavirus cases, forcing a global lockdown, which led to the destruction of oil demand on a scale never seen before. According to research firm Rystad Energy, during April, there was excess supply of about 27.4 million barrels per day (mbpd).

Despite the agreement by OPEC on April 10 to cut supplies by 10 mbpd, a huge demand-supply mismatch remains. This has caused a precipitous decline. Even after the Coronavirus crisis is over, the supply-demand imbalance will remain, with price expected to stay well below $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 demonstrated that their actions to manipulate price by orchestrating production cut don’t always succeed. If, they could extract a price as high as close to $150 per barrel (2008) or $117 per barrel (2014), it can also decline steeply to a low of $10 per barrel (1997) or $26 per barrel in early 2016 and to around $20 per barrel currently.

The short point is that in a market where price determination is entirely dependent on supply and demand factors — irrespective of the cost of supply — demand is as crucial. In 2008, when global demand was increasing exponentially (courtesy, pump-priming by developed countries in the wake of the 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 about $20 per barrel.

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

With a share of about 60 per cent in total oil exports, the hold of the OPEC bloc on the market has substantially diminished. Now, it needs the support of other non-OPEC exporters also to prop up the price. Even if both OPEC and non-OPEC act together, they will have to introspect whether or not by crippling resource position of importing countries (inevitable, if the price is high), they will end up harming their own interests.

This is where the clarion call given by Modi 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 maximising their revenue on the one hand and ensuring that the demand does not collapse. That the price had plummeted by 50 per cent even before the Corona pandemic should serve as a warning signal. 

For decades, oil exporters have got attuned to spending extravaganza 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 per cent of its budget is supported from oil revenue. For Iraq, another major exporter from the region, this figure is even higher at above 90 per cent. This is a dangerous situation.

With a low price scenario continuing for a fairly long period (a distinct possibility as restoration of demand to the pre-Covid level is bound to be  long-drawn), this could increase fiscal stress in these countries to unsustainable levels. For others like Mexico or Venezuela, which export much less, their economic survival is totally dependent on oil revenue, this could lead to a catastrophe.  Saudi Arabia has sensed it and accordingly, it is looking for opportunities to diversify its sources of income to reduce its overdependence on crude. In pursuit of this strategy, last year, it unleashed plans to invest $100 billion in India’s downstream sector, including refining, petrochemicals, retailing and so on.

This includes Aramco’s proposal to acquire 25 per cent equity in the $60 billion West Coast refinery and petrochemical project in Maharashtra in which 50 per cent will be owned by the Indian Oil Corporation Limited (IOCL), Bharat Petroleum Corporation Limited (BPCL) and Hindustan Petroleum Corporation Limited (HPCL) and the remaining 25 per cent by the Abu Dhabi National Oil Company (ADNOC). Aramco is also picking up 20 per cent equity in oil and gas assets of Reliance Industries Limited.

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 being more “reasonable” and “responsible” in dealing with importing countries like India.

There are lessons for India as well. First, even if it pursues indigenisation at an accelerated pace (unlikely, as during the last five years or so, despite loud talk of increasing domestic production, our dependence on import has only increased from a little less than 80 per cent to 85 per cent currently), we will continue to import an overwhelming share of our requirements.

Hence, there is dire need to improve our import management strategy that should maximise gain when the price falls and minimise loss when it increases. The current strategy has too many gaping holes or else, how does one explain an “inventory loss” (this represents the difference between the price at which the product in storage was imported and the current price) of about Rs 25,000 crore by our oil Public Sector Undertakings (PSUs) like IOCL/BPCL/HPCL due to the recent plunge in prices.

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. Unfortunately, that does not happen. When, the international 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 Government increases central excise duty (CED). In case of gas, even as CED is “nil” the price to users increases on account of high value added tax (VAT) levied by State Governments.

There is also the fortuitous benefit that accrues to upstream crude producing PSUs viz. Oil and Natural Gas Corporation (ONGC), Oil India Limited (OIL), which produce nearly 15 per cent 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 the 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  or domestic supplies, the overarching consideration in pricing should be to ensure that the product is “affordable” to the end consumers. Sans this, there will be large-scale demand destruction which is bad omen even for suppliers, including the Government-owned PSUs viz. ONGC and OIL. In short, detoxification of oil pricing is in the best interest of all stakeholders.

(Writer: Uttam Gupta; Courtesy: The Pioneer)

No Comments so far

Jump into a conversation

No Comments Yet!

You can be the one to start a conversation.

Your data will be safe!Your e-mail address will not be published. Also other data will not be shared with third person.