Prudent is a regime that conserves fuel

Earlier this month, the Opec Conference issued a statement that is interesting to note. To quote at some length: ?Having reviewed the oil market outlook, including the overall demand/supply expectations for the year 2007, in particular the first and second quarters, as well as the outlook for the oil market in the medium term, the Conference observed that market fundamentals clearly indicate that there is more than ample crude supply, high stock levels and increasing spare capacity. [It] noted that? world oil demand is estimated to increase by 1.3 mb/d (million barrels per day) in 2007? [but] this is likely to be more than offset by a projected increase of 1.8 mb/d in non-Opec supply, its highest rise since 1984? the decision? taken in Doha to reduce production by 1.2 mb/d as of 1 November, 2006 had succeeded in stabilising the market? [however] prices remain volatile, reflecting the continuing supply overhang in the market? In view of the above, the Conference decided to reduce current Opec production by 500,000 b/d, with effect from 1 February 2007, in order to balance supply and demand.?

Crude petroleum prices have been on the decline since the end of the Lebanon conflict in July 2006, during which prices had touched a historical high of $78/bbl (per barrel). After the end of the conflict, prices fell rapidly towards the mid-$60s/bbl, and by October it had fallen below $60/bbl. Opec had then proposed a new target price band of $55-60/bbl and had initiated the production cutback referred to above. It is worth wondering why a situation in which so many had expected prices to touch $100/bbl has so quickly turned into one where Opec was willing to sacrifice 1.7 mb/d in output to defend a price of $60/bbl.

The story basically starts from 2003 and 2004 when a completely unexpected boost in demand, principally from China and to a lesser extent the USA, caught the market unawares. In previous years, global demand had increased by about 0.7 mb/d and suddenly this shot up to 1.9 mb/d in 2003 and 3.1 mb/d in 2004. Chinese demand rose respectively by 0.6 mb/d and 0.9 mb/d in these two years ? three to four times the annual increase of earlier years. It is this demand shock that saw prices shoot from $30/bbl to $70/bbl. This demand shock surprised many by growing in strength and depth through the course of 2003 and 2004, providing the necessary support to ever-higher prices. Financial investors appeared to have caught on to the source of this demand shock ahead of the pure petroleum market, benefiting no doubt from their exposure to economic developments at multiple levels.

As is commonplace, these errors tend to be followed by over-correction, which then led to overestimates about Chinese demand and the world as a whole in 2005, as well as in 2006. Thus, even as it was becoming clear that demand growth in 2005 was nowhere as strong as in the previous two years, the upside surprises of the previous years acted as a drag on a market adjusting to the slowdown in demand growth. Initial estimates by the International Energy Agency put demand growth in 2005 at 1.5 mb/d, and the implicit assumption in the minds of many was that actual demand would be higher still. In any event, demand growth turned out to be 33% lower. The initial estimate of demand growth in 2006 was 1.7 mb/d, which is likely to be 40% lower. The volatile political situation in West Asia, by injecting heightened uncertainty, prevented the underlying demand profile from readjusting market prices.

On the supply side, non-Opec players were responding to the phenomenal price levels by ramping up production. At present, Opec output is less than 30 mb/d, while non-Opec countries produce over 50 mb/d, reducing the ability of the cartel to influence prices. Even if current and future production cutbacks by Opec were able to remove the ?excess supply of oil? from the market, it would at best serve to prevent further slippages in crude oil prices. It is unlikely to push prices to the levels that have been seen in the recent past. This explains the present official Opec position of targeting a price band of $55-60/bbl. Political developments that threaten supply can, of course, dramatically change the picture.

Thus, while the near-term outlook for crude prices looks better than they might have a year ago, the longer-term outlook continues to indicate higher price levels. World demand will continue to grow ? even if the huge step-up in 2003 and 2004 is not repeated ? and additional output will have to come from more expensive petroleum sources. In terms of domestic policy, that means it would be prudent to maintain a price regime that rewards fuel efficiency, especially in the use of automotive fuels ? potentially the fastest and most important component of demand that is strongly correlated to rising incomes.

In India, we are pouring a major fortune into subsidising domestic cooking gas and public distribution system kerosene. It is unlikely that political realities will allow any significant pruning of these subsidies.

Instead of bleeding the oil sector and the government, it would be advisable to consider an explicit cross-subsidy to be raised from motor spirit and diesel, especially since it can be done today by the more painless expedient of not reducing their selling prices if crude petroleum broadly remains within the stated Opec price band of $55-60/bbl?or even falls a bit lower.

?The writer is economic advisor, ICRA