BHARATA BHARATI

“India stands to gain a lot from the falling prices of commodities led by oil. Cheaper imports will help it reduce its trade and current account deficit, stabilize the rupee, help control inflation and lighten the subsidy burden on government finances. It will enable the government to carry out the much-needed structural reforms to revive growth and improve competitiveness.” – Virendra Parekh

The oil price is in free fall, down 25 per cent since June and 9 per cent so far in October. The fall is driven by a supply glut from almost all players, as well as weakening demand from key economies such as Europe and China. Current indications are that this is not a short time blip. Oil prices are likely to stay around present levels, if not drift lower, in the next few years.
 
This is good news for India, as also for many other oil importing Asian countries. The extended bull run that had hurt India by widening its current account and fiscal deficits, besides raising subsidies and weakening the rupee is now reversed.
 
The current downtrend in oil is remarkable for many reasons. Prices are falling even when a number of oil producing countries are at war, or battling internal strife. Earlier, if even one oil producer was in trouble prices would harden immediately. Also, Saudi Arabia, the world’s traditional swing producer, has done nothing to defend the floor price of $100 a barrel for Brent crude, which had not been breached since July 2012. That is why expectations are that prices might fall further, driven by a combination of ample supply and weak demand outlook.
 
Oil market has suffered a big supply shock in recent months. In fact, the world’s output of oil has been rising strongly since April last year. According to International Energy Agency, OPEC pumped more oil than it had in 13 months in September, while non-OPEC producers added 2.1 million barrels a day during the month, or more than 2 per cent of global daily demand.
 
The biggest recent change has come from within the oil exporters’ cartel. Saudi Arabia shocked the rest of OPEC by cutting forward prices for Asian delivery and by increasing oil output slightly in September (by 107,000 barrels), at a time when other exporters wanted it to cut back. Libya’s production—hit by civil war— had crashed to just 200,000 b/d in April. Surprisingly, by the end of September Libya’s output was back up to 900,000 b/d and seen heading towards its pre-war level of 1.5m b/d. Equally surprisingly, Iraq’s output is rising, too. The dreaded terrorist outfit Islamic State also extracts and sells some oil from wells under its control. The upshot is that OPEC production started to grow again in September after almost two years of decline, compounding the impact of growing non-OPEC supplies.
 
The growth in supply from non-OPEC countries, America in particular, has been even higher. Thanks partly to increases in shale oil output, the United States pumped 8.8m b/d in September, 13 per cent more than in September 2013, 56 per cent above the level of 2011 and not far short of Saudi Arabia. Russia pumped 10.6m b/d in September, not far from the highest monthly figure since the collapse of the Soviet Union.
 
Non-OPEC production is expected to remain robust in coming years, led by the continuing shale oil boom in North America. The US has already become the world’s largest producer of petroleum-based liquids—including oil and natural gas liquids. The IEA said earlier this year the U.S. had overtaken Saudi Arabia and Russia, though it still lags behind both countries in production of crude oil alone. Total liquids production in the U.S. is expected to rise above 12 million barrels a day next month and stay above that threshold until the end of 2015. That is a rise of nearly 20 per cent from last year’s average of about 10.2 million barrels a day.
 
From a long term perspective, the rising output of shale oil in the US is likely to change the dynamics of the oil market and the international politics centred on it. The US looks set to regain its role as a swing producer by the end of the decade.
 
Until the early 1970s, America was the world’s largest oil producer and the Texas Railroad Commission stabilised world prices by dictating how much the state’s producers could pump. That power was lost by March 1972 as the rising consumption and declining production eroded the state’s spare capacity. American production declined steadily from a peak of 9.6m barrels a day in 1970 to under 5m in 2008.
 
Around that time, independent producers began adapting the new technologies of hydraulic fracturing (“fracking”) and horizontal drilling, first used to tap shale gas, to oil. Total American production has since risen to 7.4m barrels a day. The fossil fuel boom has reduced America’s vulnerability to oil price swings in two ways. First, America’s petroleum deficit has narrowed to 1.7 per cent of GDP while Europe’s has widened to nearly 4 per cent, making the dollar and the US economy less sensitive to oil prices. Secondly, as production rises and import shrinks, more of the cash that leaves consumers’ pockets will return to American rather than foreign producers.
 
The Energy Information Administration, a federal monitoring agency in US, reckons that America’s oil production will return to its 1970 record by 2019. The International Energy Agency is more bullish. In its reckoning, by 2020 America will have displaced Saudi Arabia as the world’s biggest producer, pumping 11.6m barrels a day.
 
Voices are already being heard in the US for lifting the ban on export of crude oil imposed in 1975. If the ban is lifted, it will benefit not only American oil producers, but others also. A global oil market that fully included America would be more stable, more diversified and less dependent on OPEC or Russia.
 
This highly comfortable oil supply scenario is taking shape at a time when demand is projected to remain weak.
 
Early in October, IMF revised global growth for this year down to 3.3 per cent, a deceleration of 0.4 per cent from its forecast made as recently as April. The IMF sees the US growing at 2.2 per cent in 2014, the same rate as in the previous year and a substantial upward revision of 0.5 percentage point from its July forecast. Yet, it cut world growth in 2014 to 3.3 per cent and that in 2015 to 3.8 per cent due to the drag expected from the euro area (growing 0.8 per cent in 2014 and 1.3 per cent in 2015) and Japan which is now expected to grow 0.9 per cent in 2014 and 0.8 per cent in 2015.
 
The developments since then have only compounded the gloom. Germany, Europe’s largest economy shows signs of tipping over into recession. British inflation slowed sharply in September and eurozone factory output slumped in August, while the Spanish underlying inflation rate fell into negative territory for the first time in more than four years.
 
The real disappointment is China. China’s consumption of steel and power has been declining for some months and the sale of houses and start of new homes has dropped 10 per cent in the current year. In fact, the creeping downturn in China’s property market is likely to reduce its growth rate from more than seven per cent to five-six per cent and has the potential to derail the fragile global recovery.
 
All this and given the number of times IMF forecasters have got it wrong (the latest World Economic Outlook (WEO) has a separate section on this) it is very likely that even the lowered forecasts of global growth may not come true.
 
The slowing economic growth in Asia and a sputtering European economy have naturally weighed on demand for oil. The Paris-based International Energy Agency, in its closely watched monthly oil-market report released in mid-October, cut its forecast for global demand growth by about 22 per cent. It now forecasts demand will climb a meager 700,000 barrels a day this year, about 200,000 barrels a day lower than previously forecast. Global oil demand is just over 92 million barrels a day. Oil lost $4 the day IEA report was released.
 
The bearish outlook on oil as also on other commodities is reinforced by a strong dollar. The US Federal Reserve is getting ready to increase rates. The Bank of England is on the same path. The European Central Bank is already pumping more and more money into the financial system to lift inflation, though with limited success so far. This has led to ascendancy of dollar, as global funds have put money back in the US in anticipation of interest rate hike. Commodities are priced in the US currency. So, as the greenback gains in value, fewer dollars should be required to buy them. This relationship does not always hold, but at the moment it does.
 
Since consumption is weak, much of the extra output is currently going into rebuilding oil stocks in rich countries. But that cannot go on indefinitely. As the hoarding slows, prices are likely to weaken again, unless world demand picks up or oil production is cut. Neither seems imminent.
 
Ordinarily, faced with a weak demand and sliding prices, oil exporters’ cartel OPEC would step forward to halt the decline by cutting oil production. This time around, however, OPEC is ridden with a deep split among its members who do not seem willing to rein in output to help bolster prices. Instead, OPEC members have been reducing prices in an effort to boost, or defend, their own global market share. A call by Venezuela—one of the cartel’s members most sensitive to falling oil prices—for an emergency meeting has so far been ignored by other members.
 
Saudi Arabia, as noted earlier, has acted on its own. It has cut its prices to Asian and European buyers, essentially undercutting other OPEC members. It also ramped up output by 100,000 barrels a day in September, to 9.7 million barrels a day. The question is: why?
 
One theory is that the Saudis want to discourage investment in non-OPEC supply, to support higher prices in the long run. A simpler explanation is that the Saudis are trying to browbeat other OPEC members into acting like members of a cartel. In recent years, the kingdom has been forced to act largely alone to steady the market. Letting prices fall should turn up the pressure on slackers such as Venezuela and Iran, which need far higher crude prices than Saudi Arabia to pay their bills, ahead of OPEC’s next meeting in November. But Kuwait’s oil minister remarked recently, “I don’t think there is a chance today that [OPEC countries] would reduce their production.”

Whatever the explanation, the Saudi brinkmanship is hardly a sign of strength. It suggests instead of driving the markets, the once-mighty cartel is now being driven by markets itself. 

So clearly, there is downward pressure on oil. But how far can the price fall? Analysts say there is a natural floor for oil prices: the price which U.S. shale producers need to keep their wells flowing profitably. If prices fall below that so-called break-even price, producers could rein in output. The lost supply could then bolster prices.

Most analysts, however, say that the floor is yet to be reached. According to IEA, only about 4 percent of U.S. shale oil production needs prices above $80 for drillers to break even. Producers are getting more oil per dollar spent drilling, driving costs down. “There’s not one single drop of oil which cannot be produced for commercial reasons with today’s price,” the IEA’s chief economist, Fatih Birol, said in an interview.
 
India stands to gain a lot from the falling prices of commodities led by oil. Cheaper imports will help it reduce its trade and current account deficit, stabilize the rupee, help control inflation and lighten the subsidy burden on government finances. It will enable the government to carry out the much-needed structural reforms to revive growth and improve competitiveness.   

On the flip side, the weakness of Europe and the slowing of China mean that India’s export markets will struggle. China managed to grow rapidly over the last decade on the back of a booming world economy. India will need to be extra competitive, for it will need to win export orders during a global slowdown. In order to make that happen, structural reform will have to be deep and painful – taking advantage of the respite offered by cheaper commodity prices. Policy makers in New Delhi cannot afford to waste the opportunity provided to them.

» Virendra Parekh is the Executive Editor of Corporate India and lives in Mumbai.

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