High energy prices affecting GDP growth

News about crude oil is usually frequent and occasionally dominant as it has been for sometime now. The cascading effect of oil prices is soothing that one cannot ignore.

Oil prices have been increasing consistently for the last seven years and its seeking price inelasticity and ability to repeatedly touch historical highs have spooked the most adventurous of analysts. Some have simply decided to speak of exponential price increases and others are doubly sure that prices will fall soon. The factors affecting the prices and the views from both the sides of the fence are enumerated below.

Geo-political tensions seem to go hand-in-hand with oil exporting countries and the heightened tensions are the reasons for many price increases which take a long time to die down. While market bulls point to a particularly disturbed environment in the Gulf and Nigeria currently, the bears will argue that though the post 9/11 period (terror attacks in US) was rough it is relatively steady today. But the simmering tensions worldwide do keep oil on the boil.

As the global demand for oil continues to grow a question remains whether this growth will be sustained. The Jury is still out on whether Chinese (and Asian) growth will slow down and several statistics are being circulated to prove it one way or the other. But it is significant to note that till now there is no evidence to prove that the high oil prices have led to a fall in consumption. Perhaps the growth in China, India, Brazil, Russia and other fast growing nations makes up for the potential drop in demand from the US due to its recessionary phase.

Surely the world is not out of oil. But the last few years have had a reserve Replacement Ratio of less than one – a jargon for saying that more oil is being drilled out of the ground than being discovered. Considering that we are comfortable for another couple of hundred years in terms of discovered oil, lets’ assume there is nothing to worry about. But in a shortage situation any reason can lead to panic. However in a high demand situation, every factor will get exaggerated and put upward pressure on prices.

Oil’s immediate availability is a matter of concern. After prices tanked to US$11 per barrel in the late 1990s, new refineries shelved their plans and expansion stopped. Today, the shortage of refineries has become a hurdle in the market. Even if enough crude oil is pumped, the existing refining capacity is less to process it into end use products like petrol and diesel. This mat change as early as 2009 when several refineries worldwide start their options, including India’s private sector Reliance Petroleum. Till then end products will be costlier as refiners have raised their margins.

The newly acquired prosperity of several nations, including India, has played its part in convincing oil exporting countries to raise prices to levels which the market can absorb. This is evident from the fact that oil prices have grown in tandem with the global GDP growth in the last few years and the increasing affluence has ensured to take care of the price rise. Only time will tell if the current levels are sustainable.

The strength of the US dollar or the lack of it has aggravated the problem. As oil prices are denominated in dollar, a weak dollar may be forcing the exporters to increase their product prices to make up for their loss compared to other currencies like the euro and yen. As about 30% of the world’s production comes from the Organization of Petroleum Exporting Countries (OPEC) group decides oil production and prices intermittently, the dollar factor is now accepted as one of the reasons for the recent price rise. As corollary oil is expected to fall when the dollar has strength – once the US gets out of the financial mess it created.

Financial investment is also estimated to have fuelled the top 10 to 20% of the price increases consistently. In other words blame futures trading for this. According to a US agency which monitors this, the percentage of speculative position of the entire trading basket has remained the same for many years. More money has flowed in as investment but this is offset by increased consumption trading and price.

While it is impossible to define which price is too high for world markets to absorb, there is also a certainty that the number exists. And at that level, the high prices will stabilize before falling. Thus high prices are not only the problem but also the solution. It is possible that the recent petering out of GDP growth globally is partly due to high energy prices.