for NDTVProfit.com
Thursday, May 29, 2008 (New Delhi)
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Alarming predictions are being made that crude oil may even touch $200 a barrel in the foreseeable future. Well, truthfully speaking, it’s not impossible. A similar prediction could have been made a year ago when crude was at $65; it’s over double that now and a 100% jump within a year was unthinkable then. Nevertheless, the situation can only be described as potentially explosive, no pun intended.
Crude oil dominates world energy demand and is crucial for any country’s economy—crucial enough to wage war on as events have shown in the last four decades. We must also keep in mind that price volatility is nothing new in crude oil and it has seen several crests and troughs. Last year’s horror scenario is being played out and we are about to take a random walk through the possible effects of very high oil prices in a very short time.
To start with, alternative fuel would get more expensive because it is benchmarked to the price of crude. That means higher prices of sugarcane-based ethanol and biofuels. This will make farmers shift from growing wheat and similar agri-products to maize or sugarcane or soya. The acreage of wheat and similar crops would thus decrease though consumption would remain the same—leading to price increase in a whole range of agricultural produce.
Another effect could be lesser vehicles on the road due to high cost of petrol and diesel. While this would mean less traffic, it will also put pressure on the public transport systems of cities, most of which are already at breaking point. Besides, inflation would be rampant and all- encompassing because cost of transport is a determinant of prices for virtually all types produce. Many countries will certainly consider rationing as an option till such time that prices are down to acceptable levels.
It must also be acknowledged that high crude prices can lead to global inflation, degrowth and even stagflation. In fact, if China slowed down, it would change forever the economic and geo-political situation in the world today—because Chinese dominance on the world stage is underpinned by its strong economy which till now seems immune to such price shocks. Besides, many oil-importing countries would see changes in their currency valuation.
Another macro effect would be the concentration of wealth in the hands of oil-exporting countries. Of the 85 million barrels produced and consumed every day, about 30 million are from OPEC countries. In other words, a $60 per barrel price increase from here on means an additional $1.8 billion added to the oil nations’ kitty daily—over and above the equivalent profits already being made! (OPEC members also have two-thirds of the world’s proven oil reserves.)
Of course, they would then invest the money in certain commodities like gold and real estate, since the dollar would depreciate further, leading to increase in prices of certain assets. Gold would be a major beneficiary with all investment funds parking money in gold to hedge against oil-led inflation. Such a situation would hurt the poor and the poor counties the most, leading to increase in global poverty.
The very poor will end up funding the very rich; indeed that process is already in motion. The political effects cannot be ignored because governments will be under pressure from the populace to control inflation, but since crude oil pricing is an issue out of their control, sustained increase could even lead to civil war in economically weaker countries. But high prices are not only the problem but also the solution. With increasing oil prices, more refineries are being planned and constructed; there is an increasing investment in research and better technology to extract oil from marginal fields; and there are large-scale efforts in reviving old oil fields which were earlier not viable because they carried relatively less amount of oil or were in terrain which was inaccessible and therefore expensive to extract oil from.
Besides, use of alternative fuels will increase faster and more research funds will go into them. Energy efficiency is already an important issue in the wake of a continuous increase in crude oil prices and this will become a watchword for more and more industries and processes. History shows that such price increases are never sustained and typically end in a downward spiral if prices go beyond what markets can absorb: abnormally high prices lead to lower demand which in turn leads to lower prices in a semi-continuous process.
Oil exporting countries are of course acutely aware of these pitfalls and are keenly watching the reactions to price increases. They would not like to see a repeat of the situation when high prices considerably slowed demand from South East Asian countries. I expect that the oil nations would help cool prices by pumping up production as soon as such a trend is spotted.
It’s a scary world to live in, but markets are all-powerful, all-knowing—and great levelers, too. Markets may be irrational in the short term but quickly shake off unfounded factors and level prices based on demand-supply equilibrium. A $200-per-barrel world today looks as improbable as $140 did a year ago. And in the unlikely event of oil reaching the $200 mark, this author will be combining his morning exercise with his office commute—on bicycle!
