Adding "Oil" to the Fire

"We might forget about lighting fires for now - the oil production seems to have "peaked". The D-day is not far, when we would walk to offices and come back, use solar energy to power air-conditioners on clear days, and wind energy on the not-so-clear days!" That is what the speculators who were and are bullish on oil might want the whole world to believe!

I am no oil-industry expert. Neither am I a financial market specialist, who, like fortune-tellers, can accurately predict whats gonna happen next. However, what I do believe is that such wild fluctuation in oil prices is something uncalled for. How can a resource, which was priced $31 per barrel a few years back (2003), was worth $150 a few weeks back, and now costs $90 odd? Is that reasonable by any yardstick?

I still remember those last few days of my IIT life, when, Mayank Jha, Priyesh Neema and myself had created a "demand" for biofuels on paper, working on a business idea, simulating scenarios when oil price would cross $70 per barrel, making bio-fuels economically viable. Never did we realise that biofuels compete for land (another limited resource) with food grains and a host of infrastructure projects. Too much of a digression - but I do not think bio-fuels are economically viable right now. Maybe fuel cells or some other technology that uses some unlimited resource (like water) is what we really need.

Anyways, a recent discussion with one of my colleagues, Shreerang Godbole, has inspired this post -a discussion triggered by the recent collapse of Lehman Brothers, the free fall of oil prices and hence, the realization that economics does affect day-to-day life.

What do oil prices really depend on? Traditional economics says - demand and supply. High demand, low supply implies higher prices. Simple.

But where is the demand from? Who are the suppliers? I am afraid I haven't done any due diligence here, but oil demand is really not stagnant world wide and is definitely growing. In the recent years, it might have been triggered by economic boom in India, China and other developing countries. It might also have been boosted by the Olympic Games in China last month! Another fact to be considered here is that oil demand might be elastic, but one suddenly doesn't start using more oil or less oil overnight (as compared to say, expensive clothes). If the price does rise, it takes some time for consumption to come down as businesses change strategies, and households change their lifestyles. Elasticity is over a longer term not over a very short term.

And the supply? OPEC countries - majorly Arab countries, some African countries, Russia, Mexico, countries around North Sea etc. Supply too has been increasing over the years, with better methods of exploration and extraction. Iraq invasion might have reduced supply from that part of the world for now. However another issue is that most oil producing countries are not very open about their production capabilities and reserves left. They treat oil as a 'national treasure'.

But, then what about things like speculation and dollar weakening? Well, yeah, coming to them - every major financial hub trades derivative contracts on oil. For the better part of last few years, number of people going long on oil have been much more than those short on oil (i.e. people expecting oil prices to rise have been larger in number). This implies that prices of call derivative contracts on oil would increase (i.e. value of contract which says that the price of oil would be 1.2X three months from now if the present price is X, would also increase - since number of buyers of these contracts is larger!). And hence, derivative markets expected oil prices to rise.

Now, combine this with the nationalistic pride of oil supplying countries. Agreed that derivative contracts are just paper contracts and settle in cash than in actual oil barrels, but consider a situation where you were an oil merchant and the market world-wide says that oil price will rise, and the market world-wide doesn't know how much oil you hold. What would you do? Obviously, you would sell in as small quantities as possible at prices as high as possible. That might have been the case all this while!!

What about dollar weakening? Well, that is akin to changing the scale. Dollar is a globally accepted currency to settle contracts, close deals etc. However, with the US trade balance worsening (imports increasing more than exports), demand for currencies other than dollars increases (a US importer would pay an Indian exporter in rupees). Hence, people want lesser amount of US dollars for trade and more of other international currencies. And therefore, US dollar value goes down with respect to other currencies. This only means that if we had a hypothetical stable universal scale of measuring value, called aana then although the price of oil remained X annas, since dollar value went down from Y dollars per aana to 2Y dollars per aana, the value of oil in dollar terms went up from XY dollars per barrel to 2XY dollars per barrel.

Then why did oil prices crash with the fall of Wall Street giants? Well, bears have outnumbered bulls in the financial markets for sure. Oil prices had been high for a decent amount of time. That would have resulted in demand elasticity coming into picture. Net growth in demand would have come down. All this leading to reduction in prices.

Thus, to me, it appears that supply uncertainty, bullish-bearish outlook in financial markets and international trade - all have a role to play in this oil price fluctuation.

I don't know what is in store for future. The best bet for us, and for the planet, maybe, is for us to live within our means (avoid credit crunch situations like the one we face today), accelerate ways and means of exploring & extracting oil efficiently, start saving energy in our own small ways, and wish that scientists make fuel cell/fusion/solar energy/wind energy solutions more economical soon!