Two weeks ago, this column discussed the tipping point in oil price. There is increasing evidence that the tipping point was $50 for a few economies in Asia. Indonesia is in the middle of a mini-crisis. The currency has weakened significantly against the US dollar. Local bond yields had gone up. US dollar-deno-minated bonds of both the Indonesian government and that of corporations with good fundamentals have suffered from price declines (yields have gone up). The market is looking for signs of leadership.
The government, well aware, that the Suharto regime was partly toppled by the decision to raise fuel prices, is waiting for the price of crude oil to drop and solve its problems. Usually, Murphy?s Law prevails in such circumstances. In any case, markets could remain irrational (or stay on a path different from what fundamentals dictate) longer than governments could stay solvent.
On Friday, the Indonesian government held a press conference to share the budget assumptions for 2005-06. Apparently, every $10 increase in oil price increases deficit by slightly more than Indonesian rupiah (IDR) 2 trillion ($200 million). Currency weakness by 300 IDR/USD increases deficit by IDR 2 trillion. Interest rate increase by the central bank by one percentage point raises the deficit by another IDR2 trillion. On each of the above, the assumptions made for next year?s budget has been optimistic ($40 per barrel of oil; IDR exchange rate for the US dollar at 9,400; the central bank rate at 8%). The current oil price for West Texas intermediate crude is around $67. Indo-nesian crude basket is usually $5 below the price of WTI crude. The current exchange rate is IDR 10,400 and the current central bank policy rate is 8.75%.
The market is pushing up the dollar against the IDR and domestic currency bonds are dropping in value. This offers a foretaste of what could happen in other markets that hesitate to pass on international prices to domestic consu-mers. Placed in a global context, the situation in Indon-esia should not be allowed to get out of hand. It is the world?s largest Muslim country and Southeast Asia, despite its large Muslim population, has, by and large, re-mained free of terrorist influence.
? The mini-crisis in Indonesia doesn?t bode well, particularly for SE Asia ? The run-up in crude oil price has also begun to foreshadow grim scenarios ? To avoid fall-out, democracies need to prepare people for higher energy prices |
If the Indon-esian economy deteriorates, the local population would vent its anger against the government. If Indonesia were to slide into anarchy or reveal a wrong preference for a non-democratic role out of a mistaken craving for the superficial stability that military rule provides, it would mean a huge setback for Southeast Asia that is trying to redefine a role for itself in the aftermath of the Asian crisis of the 90s and the emergence of China.
Hence, it must be clear that the run-up in crude oil price has now begun to foreshadow grim scenarios, both for the global economy and for global political stability. The longer it is allowed to continue, the more dangerous it is going to be. Clearly, one element of the response to the rising price of oil is lower consumption. However, that is unlikely to happen unless and until consumers face higher prices. Otherwise, their consumption habits would not change; demand would remain high and so would prices. Hence, no matter how unpalatable, democratic governments have to get the message across to people that international prices can?t be suppressed for too long.
Once again, the situation underscores two imperatives for demo- cracies that are usually forgotten. One is that the public would take bitter medicine from the government if they also enjoy the fruits of good governance. In India, and in most emerging markets, this is not the case. Second, subsidies to the poor have to be imaginative and effective. Usually, direct income support rather than price manipulation is clearer and transparent and brings about desired behaviour on the part of all players.
The second element of the response to higher crude oil price is to examine speculation in oil price and for international governments to lean on speculators. Obviously, it is hard to separate out the speculative component in the price of crude oil from the fundamental element. Not just in crude oil but in any price determination model, the risk-premium and speculation components are subjective. Hence, quantification of the component in the current price of crude oil, attributable to speculation, is rather difficult. However, anecdotal evidence points strongly to the presence of speculation in crude oil trading. More than 50% of the open positions in crude oil futures is held by speculators?who have no direct interest in crude oil?as compared to commercial hedgers who have a business interest in crude oil (oil producers or consumers). That is evidence of speculation.
Second, the current price of crude oil is more than three standard deviations above its five-year moving average. Certainly, there is a case for the price of crude oil to be higher. ?By how much?? is the vexing question. Non-OECD consumption (million barrels of crude oil per day) is about 15% higher than its 10-year average. OECD consumption is about 5% above its 10-year average. The price of WTI crude is about 153% higher than its 10-year average. There is clearly some unhinging of the price of oil from fundamentals. If the price truly reflects genuine fear over future supplies, then there is a lot more that world governments have to do about hydrocarbon consumption. It beg-ins with preparing the public for higher energy prices. This brooks no delay.
Further, a preference for free markets needs to be combined with prudent regulation. The NY attorney general showed the American corporate sector in poor light. The California energy crisis revealed that free markets were abused. It is time the spotlight is turned on crude oil trading.
The writer is the founder-director of Libran Asset Management (Pte) Ltd, Singapore. These are his personal views
