predicament in Europe has thus far diverted attention from another crisis
that has been brewing for some time now: a spike in global oil prices.
The price of oil has risen by close to 20 per cent since the beginning
of this year, raising the prospect of it touching the peak levels it
had reached in July 2008. Brent Crude was selling at $128 a barrel at
the beginning of March, as compared with its less-than-$110-a-barrel
price at the end of December (Chart 1). This spike occurred on top of
the continuous increase in prices recorded since December 2008, when
oil prices touched a low influenced by the global crisis. Prior to that
the free-on-board (FOB) price of Brent crude had collapsed from more
than $140 per barrel in July 2008 to less than $35 a barrel by the end
of that year. But though the recession has persisted even after that,
the price trend has reversed itself to reach its current high levels
even by historical standards. In fact, if Europe was not experiencing
the stagnation it is struggling to address, oil prices could possibly
have been at another record high.
From a purely demand-supply point of view, the rise is indeed surprising.
The US, the world's largest importer (Chart 2), has seen its import
levels drop significantly. One reason is that the combination of a recession
and higher oil prices has restrained oil demand. According to official
sources, the demand for oil in the US was down by 2 per cent last year.
In addition domestic supply has improved, partly because of increased
domestic production and partly because of the availability of alternative
fuels such as ethanol. As a result the share of imports in US oil consumption
was down to 45 per cent from 60 per cent in 2005. Aggregate US imports
of crude oil are placed at 8.91 million barrels a day in 2011, which
was the lowest it has reached after 1999. All this should have worked
to moderate international oil prices.
It could be argued that the fallout of these trends in the US has been
partially countered by the increase in Asian demand. China and India
are the second and fourth largest net importers of oil. But in their
case too growth, though higher than in Europe, the US and Japan, has
slowed after the crisis. So demand from those sources too would have
been lower than would have otherwise been the case.
If prices have risen sharply despite these trends, it is principally
because of the uncertainty resulting from political developments in
the region. Ever since the outbreak of diverse oppositional movements
in West Asia and North Africa, uncertainty with regard to supplies has
been on the rise. The political disruption in Libya in particular was
seen as having had an adverse effect on supplies. But the factor that
seems to have provided a fillip to the price rise was the standoff between
Iran and the West, ostensibly over the former's nuclear programme. Iran,
which is third largest net exporter of oil (Chart 3), is already subject
to US sanctions that are targeted at limiting its oil exports. In fact,
in recent times, the US has intensified its efforts to discourage global
consumption of Iranian oil. To add, Europe announced that it would also
impose an embargo on oil imports from Iran starting from July this year,
and Iran responded by threatening to immediately cut supplies to six
The price spike, however, was not because of any immediate shift in
the supply-demand balance and shortfall in oil availability resulting
from these factors. To start with, the announced European embargo and
Iran's response to it have yet to be implemented. Secondly, the US has
not been able to persuade all countries to stop oil imports from Iran,
which would have effectively cut off its supplies to world markets.
A typical case here is India. India imports around 300,000 barrels of
oil a day from Iran, which amounts to a significant share of its oil
consumption. Yet India seemed to be succumbing to pressure from the
US, first with respect to a transnational pipeline project involving
Iran and subsequently with regard to foreign currency payments arrangements
for Iranian oil. But finally, India has worked out a rupee payment deal,
which secures its supplies from Iran as well as opens up opportunities
for trade reminiscent of India's relationship with the erstwhile Soviet
Union. Besides India's action, Iran's supplies to the world market are
likely to remain untouched because of the importance of Asia in its
total exports. China, India, Japan and South Korea account for more
than 60 per cent of world imports of Iranian oil. So long as these countries
protect their own energy security by not cutting off their relationship
with Iran, a chunk of supplies involved in the global trade in oil would
not get cutoff.
Finally, as in the past Saudi Arabia has helped cool oil markets with
its spare capacity and its willingness to ramp up production to cover
any unmet demand. Saudi Arabia had made an important contribution to
reining in oil prices during the Venezuelan oil strike in 2003, the
invasion of Iraq in 2003 and the Libyan crisis last year, and promises
to continue to do so.
If despite all these factors that keep the supply-demand balance in
control, prices have risen, it is because of the speculation engaged
in by global finance by exploiting the prevailing political uncertainty.
It is known that energy markets have attracted substantial financial
investor interest since 2004, especially after the decline in stock
markets and in the value of the dollar. Investors in search of new investment
targets have moved into speculative investments in commodities in general
and oil in particular. Hedge funds and other investors have been buying
into the commodity, fuelling the price increase even further.
The problem is that this consequence of speculation is not just a short-term
price spike. If speculation feeds on political uncertainty, then we
could be looking at a long-term problem in oil markets. As noted earlier
(Chart 1), looking back it emerges that nominal oil prices were rising
gradually from 2003 till the middle of 2006 and sharply from early 2007
till the middle of 2008, after which we have witnessed the dip and revival
since 2008. That is, the last decade, when political turmoil intensified
in the West Asian region, has been a period of an almost continuous
increase in oil prices, irrespective of the state of global demand.
This is by no means a normal inflationary trend, since even the real,
consumer price inflation-adjusted price of oil has been at high levels
in recent years. Consider, for example, the price of oil imported into
the US, measured in inflation-adjusted terms or in ''2012 dollars''
(Chart 4). The chart shows that the real price of oil has been on the
rise since 1999 and especially since September 2001, when the US responded
aggressively to the twin towers attack. What is more, the peak 2008
price in 2012 dollars was above the high prices recorded in the 1970s,
which was when the world experienced the effects of the formation of
OPEC, the Iranian revolution and the Iran-Iraq war. In sum, ever since
''9/11'', oil prices have not just been on the rise but seem to have
found a higher average level when compared with trends since the formation
of the OPEC cartel.
It has been known for sometime that this long-term trend was not really
the result of fundamental demand-supply imbalances but driven by financial
speculators exploiting political uncertainty. In April 29, 2006 the
New York Times had reported that: ''In the latest round of furious buying,
hedge funds and other investors have helped propel crude oil prices
from around $50 a barrel at the end of 2005 to a record of $75.17 on
the New York Mercantile Exchange.'' According to that report, oil contracts
held mostly by hedge funds had risen to twice the amount held five years
ago. To this had to be added trades outside official exchanges, such
as over-the-counter trades conducted by oil companies, commercial oil
brokers or funds held by investment banks. And price increases had also
attracted new investors such as pension funds and mutual funds seeking
to diversify their holdings. In fact, in November 2007, when Royal Dutch
Shell, Europe's biggest oil company, presented its third quarter results,
Chief Financial Officer Peter Voser argued that: "The price (of
oil) seems to be driven by some speculation and also has a political
premium in it rather than actually some of the fundamental drivers."
These trends have only intensified since.
Not surprisingly, in 2008 the Organisation of the Petroleum Exporting
Countries (OPEC), which is normally held responsible for all oil price
increases had asserted that oil has crossed the $100-a-barrel mark,
not because of a shortage of supply but because of financial speculation.
OPEC's contribution was indirect and unintended if at all. As A.F. Alhajji,
Energy Economist and Associate Professor at Ohio Northern University
had argued in the Financial Times, even when some OPEC countries are
to blame it is because: ''As oil prices have increased, so have their
(OPEC countries') revenues. Some of these revenues found their way into
funds that speculate in oil futures.'' In his view, it was in this way,
ironically, that ''petrodollars'' have helped drive oil prices to record
In sum, a combination of political uncertainty, partly generated and
sustained by US and European foreign policy, and the operations of global
finance, has taken the world into a higher oil price regime. Such uncertainty
and the accompanying speculation hold out the threat of an age of ''high
oil''. We seem to have forgotten that. But recent developments are once
again bringing that truth to the forefront.
article was originally published in the Business Line on 5 March 2012.