Why spiralling oil prices?

By Zubeida Mustafa
Source: Dawn

LAST week the international oil price, which has been rising for some years now, touched a high of $70 a barrel. Seven years ago it was $10. What it will be next week one cannot say for Hurricane Katrina has forced the closure of five big refineries and halted nearly a quarter of the United States’ oil production located in the Gulf of Mexico region.

With oil experts saying that the price will rise further, the prophets of doom are now active predicting an “economic shock” that is a global recession as has happened before when oil prices shot up. In Pakistan, the petrol price was pushed up to an unprecedented Rs52.61 per litre and one wonders how this will affect the economy and the future projections of economic growth made by the policymakers.

Two key questions to be asked are: what is the cause of this oil price rise? And how has the world economy continued to grow in spite of this spiralling rise in oil price? The obvious answer to the first question lies in the economic law of supply and demand. With China and India enjoying an economic boom, their demand for oil has been growing — China’s oil consumption in 2004 increased by 15 per cent. America, which is the world’s biggest oil consumer — 20 million barrels a day today with the projection for 2015 being 25 million barrels — has also fuelled this demand in a big way.

Although enough oil is being explored, production level and, more so, refining capacity have not kept pace with the demand. Hence the acute shortfall. According to one source, oil production has grown by 8.3 per cent since November 2001 when oil cost $17.50 per barrel but demand has increased by 8.6 per cent in the same period.

Add to this the “fear premium” and the financial speculation factor and it would explain this phenomenal rise in oil price. Fear is something new to have entered the oil market. With political volatility, terrorism, civil strife and wars (such as the American invasion of Iraq) affecting oil production in a big way, the producers have increased prices to cover up for future losses and they have not invested in increasing the refining capacity proportionately to the rising trend of consumption. According to one estimate, the fear premium may have added as much as $15 per barrel to the cost of oil.

Given the fact that Opec operates as a cartel — it accounts for 60 per cent of the world oil production — it is not surprising to find it speculating and manipulating the prices to its own advantage. It has been observed that whenever the oil stocks in the OECD countries has started to rise, Opec has lowered the oil quotas to reduce supply and thus prevent the price from falling.

But the moot question is how has this high price level been sustained without affecting the world economy? Normally in such a situation either a market corrective mechanism comes into play much before the price hits the roof, or recession and inflation set in. Neither of this has happened this time.

A number of explanations are offered by economists. One is that the price increase has been gradual as a result of which companies and individuals have managed to adjust to it. It is also said that many industrialized economies are not so oil- dependent now.

One estimate says that European countries use half as much oil per dollar of GDP as they did in the 1970s. The Economist of London attributes this to “improved energy efficiency, a switch to other sources of energy and a shift from manufacturing to services”. The paper adds another factor. The low rate of inflation (thanks to the competition from China) has allowed central banks to hold interest rates low.

The industrialized economies will turn this situation to their advantage. In 1973 when the price of oil rose sharply after the Suez war, offshore drilling in increasing water depths and challenging environmental conditions became economically feasible and many independent oil producers emerged to break Opec’s strangulating hold over the oil market.

Even today innovative and sophisticated technology is enabling oil companies to reach the oil residue in the reservoirs that was previously abandoned as being uneconomical. It is believed that the recovery rate is no more than 33 per cent of the oil in place in a reservoir. Tomorrow better technology might push up this rate.

There are other sources of energy which are being actively explored as the rising oil prices make them more economical now. For instance, biofuels are receiving a lot of attention. The production of ethanol is rising as new plants are mushrooming in different countries. China has built the world’s biggest ethanol plant and is planning another one.

The problem is that the smaller Third World countries are the ones at the greatest risk. They may fail to keep pace with new technology and not be able to absorb the high price of oil as comfortably as the rich countries have managed to do. Here comes the crunch. Already many countries have felt the “oil shock”. In Indonesia there have been lay-offs from factories. The Philippines is considering a four-day work week and petrol rationing. South Korea faces an economic slump in the offing. What has Pakistan’s response been? It has shown an equanimity that is amazing. The government has been periodically raising the price of petrol, diesel, kerosene and furnace oil trying to keep pace with the international oil price. Thus the price of petrol has shot up by 65 per cent in the last two years. The motorists swallow every raise with unheard of patience. It is the bus owners who create a rumpus but the idea of that is to obtain permission to raise the bus fare.

They recover the higher rates of petrol from the commuter. It is the common man who ultimately has to bear the brunt of what is happening in areas far from home. Oil price rise is reflected not just in the higher cost of travel: it affects the price of everything that has to be transported. It boosts up inflation which is already high in Pakistan.

So far we have not heard much of a conservation policy which seeks to lower consumption so that we have to import smaller quantities of oil. Petrol rationing could be considered even though it would be difficult to enforce it, given our nonchalance towards discipline and self-restraint. The government should reduce its revenues on petrol and pass on the benefits to the common man until the oil prices drop and stabilize again.

Footnote: It is time the Karachi administration conducted an exercise to determine the rate by which petrol consumption has gone up since the authorities decided to dig up the whole city on the pretext of modernizing our road networks. Has any automobile engineer calculated how much fuel consumption of Karachiites has increased in view of the massive traffic jams and the movement of vehicles on roads full of potholes and huge mounds of earth?