The time has come to return to fundamentals. There is understandable perplexity as to why the price of crude oil has jumped from around $80/barrel in February this year to close to $140/barrel today. Demand has certainly not shot up and there have been no significant interruptions in supply. Speculation by the paper traders on Wall Street seems to be the explanation and there is evidence to support that view. The volume of oil futures contracted on the NYMEX has increased significantly and the Commodity Futures Trading Commission (CFTC) has estimated that 68% of the NYMEX oil futures contracts are now held by speculators?up from 57% three years ago.
The question, however, to which there is still no unambiguous answer is whether speculators are alone in driving up the price or whether their actions are reinforcing an underlying trend. The CFTC has done an analysis of the factors behind the surge beyond $120/b. Their early conclusions are that the commercial participants (i.e. oil companies, airlines and utilities) are the first to respond to new market information and that the non-commercial participants have only consequently adjusted their futures position. Two other studies have also in some sense suggested that there is no ?oil bubble? similar to what we saw in tech stocks and real estate and that speculators are not alone in driving the price of oil beyond its fundamental value. UBS surveyed 1,048 equity analysts and strategists. 56% of the respondents said there was no bubble. A second poll of 324 energy investors saw 67% vote for ?no bubble?. The voting pattern does reveal, of course, that a significant number believe otherwise. Consequently, it would be wrong to conclude that speculators are not responsible. But it would be right to perhaps say that there is no conclusive answer and that people simply do not know why prices are so volatile.
It is against this backdrop of opacity and confusion that I am advocating that governments now focus on underlying long-term fundamentals. I believe it is important to do so because the choices that governments make today are what will shape production and consumption patterns in the long term.
There are three underlying long-term fundamentals.
First, the demand for energy will continue to grow. This is because of the growth in population (the UN has estimated that global population will increase from 6 bn today to 9 bn by 2050) and increasing prosperity.
Second, the supply of energy from existing resources will struggle to keep pace with demand. The production of oil and gas from existing fields will taper off and it will not be easy to offset this depletion through new discoveries. Coal will grow but its potential will be limited by infrastructural inadequacy (ports, storage) and transport bottlenecks?not to speak of environmental concerns. Bio and nuclear will increase their share in the energy basket but their contribution may not be meaningful. Third, the environment will face increasing stress. We may moderate the use of fossil fuel but we cannot replace it totally. The consequential emission of greenhouse gases will deepen concerns about climate change.
These are the three long-term fundamentals. Together they will drive the emergent energy system. The question for decision makers is how they should adapt to these underlying trends. They could respond by taking the easy option of focusing only on supply or adopt a more balanced approach by combining the development of new sources of energy with meaningful demand management and energy efficiency. The former would delay actions on carbon management and might well push countries onto a pathway that leads to CO2 concentrations above the sustainable levels of 550 ppmv. The latter could trigger decisive actions on issues like carbon trading and carbon pricing. And thereby encourage investment in carbon capture and sequestration and alternative energies. The result would be an early plateauing of carbon emissions.
What will be the path that India will follow? I do not know, but it would be better if it followed the latter path. The issue is whether it is currently positioned to shift itself towards that direction. Does it have the appropriate decision making structure to acknowledge and respond to emergent supply-demand-environmental tensions? Is our polity prepared to encourage competition and a well functioning market mechanism? Answers to these questions will determine our capability to do so or not.
The long-term expectation, however, is that prices are now onto a structurally higher plane and that prices will remain volatile both on the upside and the downside. Our objective should be to minimise the fallout of short-term volatility but at the same time to ensure that our energy system is not pushed onto a suboptimal long-term pathway. It will not be easy to get off such a pathway, and the costs of redressing the adverse consequences could be huge.
The author is chairman of the Shell Group in India. These are his personal views