1. Over the barrel: How India should respond to falling oil prices

Over the barrel: How India should respond to falling oil prices

This may be the opportune occasion to build our strategic reserves by locking in long-term supply contracts on ‘S’-shaped (floor and ceiling) pricing terms

By: | Updated: September 7, 2015 9:00 AM
oil price

India imports 80% of its crude oil requirements, and this import dependency is likely to deepen.

The petroleum market is caught in a bearish vice. Prices are down to levels not seen since 2010. There will be a bottom and prices will no doubt push up again, but the fundamentals of demand and supply suggest this may not come to be for some time. Meanwhile, oil-producing countries like Russia, Venezuela, Nigeria, Iran and the Gulf nations are facing burgeoning risks of political and social upheaval. Their social contracts are fraying. Petroleum companies are also hurting and for the first time in decades there is a talk that international majors might cut back their dividend payout. In such conditions, international interest in exploration in India will be minimal. This does not mean we should make no effort to attract such interest. What it does mean is that we will need to be innovative, flexible and focused on the “ease of doing business” index.

The petroleum market is subject to the economic fundamentals of demand and supply and the non-fundamentals of geopolitics, speculation and currency fluctuations. The latter has often bucked the former. The turmoil in Libya and Syria, sanctions against Iran, the rise of the ISIS, civil sabotage in Nigeria and the reinforcing thrust of Wall Street traders are just a handful of the non-fundamental factors that pushed the price of oil into triple digits for 39 of the 40 months prior to June 2014. Combined with the growing demand from China and India, they more than offset the impact of the surge in US tight oil production during this period.

Today, the economic fundamentals have come into their own. On the supply-side, the market is flush. This is because Saudi Arabia is determined to protect its market share and is producing to near-full capacity. It has passed on the baton of swing producer to the US. The US has not been able to accept it because it cannot control the production decisions of the 1,000-plus private oil companies that operate in the country. In consequence, the US’s tight oil production has continued to rise. Libya and Iraq have now successfully re-entered the export market, and with the P5+1 nuclear agreement, there is a heightened prospect of flows out of Iran. On the demand-side, the market is down. The reasons are the slowdown of the global economy and, in particular, the cut in Chinese consumption.

The combined impact of surging supplies and laggard demand has brought prices down from an average of $110 per barrel in June 2014 to less than $50 per barrel today.

This market situation will, no doubt, reverse one day. Cyclicality is a fundamental verity of the petroleum market.

But this may not happen for some time. An increasing number of pundits are arguing that prices will fall further before they turn around. Saudi Arabia will not turn off the spigot; technology and cost efficiency will further reduce the break-even costs of US tight oil production, and that even at prices below $40 per barrel, the marginal barrel will generate healthy returns and the Chinese economy is headed towards a hard landing. In other words, supply will remain plentiful and demand laggard. These pundits may well be right, but there is no doubt that until such time as the global economy finds a sustainable and scalable substitute to liquid fuels, the price of oil will rise again.

India imports 80% of its crude oil requirements, and this import dependency is likely to deepen. The government should, therefore, ask the following questions. Are there opportunities to be grasped in this low-price market? What steps should it take now to safeguard against the eventuality of higher prices later?

I cannot give a comprehensive answer to these questions because of lack of space, but let me offer four suggestions. I believe the government should move forward on these suggestions without delay. They can do so because none require legislative approval. They can be sanctioned by the executive.

First, the government must improve the operating environment. The supply and operating bottlenecks (viz berthing delays, customs clearances, approval delays, etc) could, in today’s straitened conditions, make the difference between investor interest and investor indifference. The government has taken a positive step in announcing its intent to auction 60-odd blocks of marginal fields to the private sector. The international majors will not respond. They have slashed their exploration budgets and are not interested in small or marginal accumulations. The smaller (unlisted) companies may, however, be interested. These companies will have tight budgets and, for them, the avoidable costs of such bottlenecks will be material. Their response to the auction could well hinge on their perception of the government’s efforts to control such costs. I should add they will also want assurance of fiscal and contract stability.

The draft revenue production sharing contract put on the MoPNG website earlier this year did not have such a stabilisation clause. The government should include it in whatever contracts they sign with these companies.

Second, in keeping with the objective to improve the productivity of our currently producing fields, the government should seek technology partnerships to enhance the recovery rates of petroleum from our larger fields, including Mumbai High.

Third, the idea of “open acreage”, wherein companies can define the areas of exploration interest and offer a work programme at any time, has been on the table for some years now. It has been resisted for a variety of reasons, none of which are compelling. Now that it is clear that the conventional exploration licensing model (NELP) will find no takers, this idea should be dusted off and implemented. The government should compel ONGC/OIL to bite this bullet forthwith.

Finally, this may be the opportune occasion to build up our strategic reserves. Of course, the prices may fall further, but it would be foolhardy to look for the “bottom fish”. This is the time to initiate conversations to lock in long-term supply contracts on “S”-shaped pricing terms (floor and ceiling).

The author is chairman of Brookings India and senior fellow of Brookings Institution

  1. M
    Mirza Zahid
    Jan 17, 2017 at 5:55 pm
    Great suggestions but I do not know how much government follow that but overall it was one of beautiful article to understand the crude oil effect in Indian market.You said rightly, reverse of the crude oil prices started since API and OPEC decide to cut their production.The American Petroleum Insute (API) has reported a sizable draw on U.S. crude oil inventories, down 7.4 million barrels over the previous week—a much larger draw that expected, and the fifth draw in seven weeks.Analysts expected a draw of around 1.7-2.2 million barrels for the week, and right ahead of the API data dump, oil prices responded upwards nearly 2 percent, in antition of a draw on a smaller scale.OPEC has said it will slash output by 1.2 million barrels per day from Jan. 1, with top exporter Saudi Arabia cutting around 486,000 bpd in a bid to end overproduction .Regards,Mirza
    Reply
    1. N
      Narendra M
      Sep 7, 2015 at 9:32 am
      (1) This is a good article. Continuous fall in price of crude has resulted in domestic price cuts for both petrol and diesel, which are of course welcome. This fall has also been helpful for containing our trade deficit, though fall of rupee has restricted country’s forex gains. But on this subject, I have a few queries: (a) Would India downsize its plans for renewable energy as crude imports have fallen in value terms? (b) Can India afford to import unlimited quany of crude when crude price remains below $ 50? (c) Lower prices of crude and consequently of petrol/diesel would naturally lead to higher s of automobile vehicles. Can we allow this? (2) On this subject I also wish to say that our government should implement a pragmatic policy about taxation (and subsidies on some) petroleum products. But this is not possible as the party in power lacks political will to implement such a policy. Also both Central and state governments have used taxes on petroleum products to increase their revenue and also the subsidies on these products to win votes. This must come to an end once for all and that is possible if a long term pragmatic policy regarding prices, taxation and subsidies for these products is implemented. Now is the right time to implement such reforms.
      Reply

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