A few quieter years & what that might bring…

All asset markets continue to be on a roller-coaster ride, not just our very own equity markets. Badly spooked markets appear ever-ready to leap at the slightest provocation, of which there is ample supply, and not necessarily slight.

But taking a step back, the view, however sombre, is not really that different from what it was six months or a year before. Crude petroleum has been soaring for years, and however much new all-time highs are highlighted by a media in tune with the mood of the moment, i.e. gloomy and concerned, the order of increase has, if anything, dropped a bit. In 2004, prices rose by about 30%, in 2005 by over 40% and till date in 2006, on average, the hike is 20%.

Even if crude oil prices for the rest of the year lock in at the current elevated levels, we are looking at a total increase of 30% in all of 2006. Considering that the world economy and most of its constituent parts have persisted with robust economic growth is, thus, quite an achievement.

But the very robust nature of this economic growth in the past several years, combined with high oil prices, has caused monetary policy in advanced economies to squeeze aggregate demand and asset prices, to prevent the otherwise likely larger uncontrolled shock further down the road. The interplay between oil prices and growth is not quite a cinch, as some are tempted to suggest, but it is certainly there. Higher fuel prices pinch consumers? pockets and squeeze some of the demand for durable consumer goods? so suggested the chairman of the US Federal Reserve in his recent testimony to the US Congress. After two years of steady rate hikes, the US interest rate is widely expected to have neared its peak. Much more, many fear, might push the system into a damaging spiral of declining asset (especially home) prices, with concurrent negative effects on the larger financial system.

In India, we will see some more tightening, too, before things settle. China has raised lending rates in recent months and has just hiked deposit rates. There will be some tightening of the bolts before 2006 closes.

The interesting question is: what next? A phase of active consolidation will invariably follow on one of rapid expansion. With tighter monetary conditions, slowing economic growth and less effervescent asset markets, some of the variables that have been set loose in recent years will have to work themselves out in the system.

The obvious candidate is, without doubt, oil or more generally, hydrocarbon fuels. Or even more expansively, the entire scope of energy. Few may remember that it was not till the 90s and in some cases the present decade, that oil consumption in the advanced world returned to its pre-1973 level. The price-driven technological adjustment was that severe. It was this sharp structural decline in demand from the developed world that caused exploration to be reduced; even that was insufficient to prevent prices from falling through the 90s in inflation-adjusted dollars. It was not till the surge in demand from China, catalysing demand conditions, that the present bout of price buoyancy (or gouging, if you prefer the word) by oil exporters gained momentum.

Minus China, there would still have been sizable demand expansion from strong growth in the developed world and in some parts of the developing one (including India). But, this would have been completely insufficient to raise oil prices to more than $40-50 a barrel, even with the many troubles in the Persian Gulf area and the rest of West Asia.

China has her hands full with seeking out hydrocarbon supplies across the world to meet the needs of her growth, while for the first time doing something about demand management. Namely, raising fuel prices and placing some burden of tax on them. The developed world is seeking new sources of energy to meet the needs of the coming decades, with less dependence on oil. This is not just a response to prices or geopolitics, but one to curtail the emission of greenhouse gases that drive the process of global warming and possibly very damaging changes in long-term weather patterns. The policy responses range from clean coal technology to renewable sources to safe nuclear reactors.

The response has obviously to be scaled over a fairly long time horizon. After all, technologies have their own maturation time horizons?some available now, some maybe 10-15 years from now and some even later. The existing stock of equipment cannot be simply replaced by fiat, so there is a time-phased process involved.

Oil exporters are savvy people and they know and fear this. The cartel always unwinds when supplies begin to exceed demand. For, that is when the less prosperous members begin to sell more oil to compensate for the fall in prices. It is not in the general interest for prices to fall by too much, for that would inevitably deliver a setback for the technological changes needed, given the long-term issues at stake.

Then again, oil consumption will not actually decline; only its share of incremental energy consumption will come down. So, some of the more expensive oil, like deep-water resources, will be needed in the years to come. And given the lumpy and huge investment costs involved, making them go bankrupt as a result of a slide in prices is not a bright idea.

Thus, over the next few years, as the world economy expands at a gentler pace, what happens in energy will be very interesting and important. The other factor is, of course, the process of production and market integration, i.e. globalisation. The world market is set to become a bit more competitive and how that affects producer response will determine the relative positioning of emerging country players in the run-up to the next bout of economic expansion some years down the road.

?The writer is economic advisor, Icra